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This lesson is part of the following series:

In this video lesson, we'll dig deeply into the role of price in an economic context. Taught by Professor Tomlinson, this video lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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Founded in 1997, Thinkwell has succeeded in creating "next-generation" textbooks that help students learn and teachers teach. Capitalizing on the power of new technology, Thinkwell products prepare students more effectively for their coursework than any printed textbook can. Thinkwell has assembled a group of talented industry professionals who have shaped the company into the leading provider of technology-based textbooks. For more information about Thinkwell, please visit www.thinkwell.com or visit Thinkwell's Video Lesson Store at http://thinkwell.mindbites.com/.

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We have been talking about a firm's total revenue; that is, the price it charges for its product multiplied by the quantity of its product it sells in a given period. But what determines the price a firm can charge for its product? That turns out to depend on whether or not the firm has market power. Market power simply means the ability to influence the price of your product. Said another way, a firm has market power if it can raise the price of its product without losing all of its customers to a competitor. Or, a firm has market power if it can lower the price of its product without attracting the entire market. Market power means the ability to set the price of your product. Now, what determines whether or not a firm has market power? And that turns out to depend on how large the firm is relative to the pool of customers.
Let's look at an extreme case, an abstraction, that economists call perfect competition. We say that an industry is perfectly competitive if it's made up of a large number of small firms, each selling an identical product. Let's break that definition down. First of all, a large number of small firms: What that means is that the output of any given firm is small relative to the market demand so that the market wants to buy a whole, whole lot more than any one firm could produce. In order to serve the entire market in that case, you are going to need a whole lot of firms, and that means a lot of competition. No one can afford to charge a price that's too high when all of these competitors are ready to step in and meet the market's demand at a lower price. What does it matter that they are all producing an identical product? It matters because when customers care about the color or the shape or the particular texture of a product, when customers care about subtle differences between the offerings of different firms, they may be willing to pay a slightly higher price for a product that looks better or smells better. But when you are competing with a whole lot of firms and you are all making an identical product, competition is very intense and it is unlikely that you could achieve any market power. You are going to have to price your product right in with the competition.
Now, there is one additional assumption we make when we call a market perfectly competitive, and that is that there are no barriers to entry; that is, that any firm can enter and exit whenever it likes. We are going to talk about that in subsequent lectures, but for now, let's focus on the first two assumptions; a large number of firms, small relative to the market, and each firm producing the same identical product. What happens in that case is the supply and demand in the market will interact to determine the equilibrium price for the product and each firm in that market takes that equilibrium price as given. That is, there is nothing they can do. If they raise their price relative to the competition, they will lose all their customers; if they lower their price, they will attract the whole market at once and they can't serve the whole market because they are small relative to the market.
Why charge a lower price when you could sell all that you can produce at a higher price? Here is how it looks in a diagram. Demand in this market and supply intersect to determine the equilibrium price and quantity. If we take this picture of market supply and demand and we project it over into an adjacent diagram that has the output of a single firm on the axis and the price that that firm can charge on the vertical axis, we will get a picture that looks like this. That is, at the going market price of P*, the going equilibrium price, this firm can sell as much output as it wants. That is the individual demand curve then of our firm. The individual demand curve says that at this price, P*, our firm is able to sell as much output as it wants. This is the nature of perfect competition: a large number of small firms each producing an identical product and each firm facing an individual demand curve that is horizontal at the market equilibrium price.
Perfect Competition
The Basic Assumptions of Competitive Markets
Understanding the Role of Price Page [1 of 1]

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